Regulatory Capital. Allen & Overy Briefing Paper No. 8 The Trading Book. CS indd 3 8/5/09 10:57:02

Transcription

1 Regulatory Capital Allen & Overy Briefing Paper No. 8 The Trading Book CS indd 3 8/5/09 10:57:02

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3 THE TRADING BOOK This briefing paper is part of a series of briefings on the Capital Requirements Directive (CRD) and its implementation in the UK via the General Prudential sourcebook (GENPRU) and the Prudential sourcebook for Banks, Building Societies and Investment Firms (BIPRU). This Briefing is for general guidance only and does not constitute definitive advice. Note: The UK FSA Handbook provisions referred to in this Briefing are based on "intelligent copy-out" of the CRD. They should therefore be consistent in very broad terms with the CRD, and therefore the rules in other EEA States. Health Warning: the CRD contains a large number of discretions for member states in implementing the CRD. The regime in other member states may therefore differ in a number of respects. Do not rely on this briefing as an accurate guide to regulatory capital in EEA member states outside the UK. BACKGROUND AND SCOPE The bank regulatory framework requires the risk weighting of assets in order to establish the amount of capital required to be held by a bank. See Regulatory Capital Briefing 1 (Introduction to Basel II) for further details. The framework for risk weighting of assets divides the assets of banks into two categories, or books the banking book and the trading book. The banking book is discussed in Regulatory Capital Briefings 3 and 4. This briefing sets out trading book eligibility requirements and key principles which underlie the risk weighting of assets in the trading book. The rules for risk weighting of assets in the trading book are complex and asset-specific, and are outside the scope of these briefings. The trading book regime is provided for by the recast CAD, which sets out the capital requirements for investment firms. It is applied to banks by virtue of Article 75 of the recast BCD. SOURCES Recast Capital Adequacy Directive (recast CAD) Articles 18-19, Annexes I, II and IV; Recast Banking Consolidation Directive (recast BCD) Article 75; BIPRU chapters 7 and 13. WHY TREAT THE TRADING BOOK DIFFERENTLY FROM THE BANKING BOOK? As a policy matter, the regulatory capital requirements associated with the trading book assets of an institution attract a lower regulatory capital burden than assets held in the banking book. This is the result of an assumption that underpins the regulatory framework that banking book assets are non-tradable and therefore presumed to be held for life whereas trading book assets are tradable and therefore can be disposed of in the market for their market value. As a result trading book positions are measured, and regulatory capital is held, on a net basis. This may be distinguished from the banking book, in which generally (with the exception of certain derivative instruments) positions are measured on a gross basis. This assumption has of course been challenged in recent months most particularly in respect of structured securities and the ability of Value at Risk (VaR) models to capture all relevant losses in the trading book. As a result the definition of the trading book, the trading book eligibility criteria and the appropriate means of risk-weighting trading book assets are all under question. It is to be expected that significant changes to the risk-weighting of trading book assets will be made by the European Commission and/or the FSA in the near future. In particular, both the Basel Committee and the European Commission have been working on proposals in relation to incremental risk in the trading book. Under the proposals the internal models will capture the credit and event risk dimension better. It is expected that if these proposals are implemented the trading book capital requirements may increase significantly. TRADING BOOK ELIGIBILITY The trading book is defined as consisting only of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book and which are either free of any restrictive covenants on their tradability or able to be hedged. Allen & Overy

4 The definition of the trading book makes clear that positions held with trading intent are those held intentionally for shortterm resale and/or with the intention of benefiting from actual or expected short-term price differences between buying and selling prices, or from other price or interest variations. Banks and investment firms are required to have a trading book policy which sets out the firm's policy for booking of positions in the trading book. Firms are also required to maintain systems and controls in relation to the operation of their trading book operations, including the creation of a clearly documented trading strategy for the position/instrument or portfolios (including expected holding horizons) approved by senior management, and clearly defined policies and procedures for the active management of positions (including establishing and monitoring position limits, and reporting to senior management): Qualifying deductions The CRD requires banks to deduct from their own funds holdings of capital instruments issued by other banks to avoid double-counting of capital. This requirement creates problems for banks who wish to trade in bank shares and subordinated notes. There is therefore an exemption for banks which are "active market makers" in the securities concerned. National supervisors are given discretion as to implementation of this exemption. CALCULATION OF CAPITAL REQUIREMENTS Calculation of market risk Market risk is the risk of losses in on- and off-balance sheet positions arising from movements in market prices. Capital requirements are primarily calculated for: risks arising from interest rate related instruments, equities and collective investment undertakings (CIUs) in the trading book; and foreign exchange risk and commodities risk in both the trading book and the banking book (application of these risks to positions in the banking book is necessary because the banking book requirements are focused on credit events and are not designed to capture risks arising from movements in market prices, so the market risk requirement, which focuses on potential fluctuations in market prices or rates, applies). Trading book positions must be frequently and accurately valued, where possible, by marking the position to market (MTM) and the relevant holding should be actively managed. This must be done daily using readily available close-out prices. Regulatory capital requirements are designed to ensure that firms hold capital for any potential changes in underlying prices or rates. Where MTM valuation is not possible, firms may use more advanced models-based approaches based on a CAD1 model (which is split in two different methodologies for options risk aggregation and/or interest rate pre-processing) or a VaR model. Firms may only use CAD1 and VaR models with permission from the FSA and provided they meet certain quantitative and qualitative minimum criteria. Under the standard MTM approach risks arising from each risk factor are calculated separately (eg interest rates, equities, commodities, FX, options, etc). Long and short positions which are otherwise very similar or identical are netted together. The resulting net position is then adjusted by a "haircut", a position risk adjustment (PRA). PRA represents a potential change in the price of the position. The size and method of applying PRA depends on the risk type of the position. Credit derivatives are subject to special calculations which reflect the additional risks that such products may contain. Interest rate and equity risks are split between general risk and specific risk, where: general risk is the risk of potential market-wide fluctuations in prices or rates, as represented by main market indices or government yield curves; and specific risk (idiosyncratic risk) is the risk of potential price or rate changes due to factors related to the issuer of the relevant investment. Firms have a choice of different methodologies for calculation of general risk. CAD1 models, which are available only to more sophisticated firms who hold a CAD1 waiver, provide for a more risksensitive treatment than other models. Interest rate pre-processing models allow firms to net positions within certain maturity buckets before applying the standard rules for calculation of interest rate position risk requirements (PRR) that Allen & Overy

5 relates to general interest rate risk. Options aggregation models allow greater recognition of netting within an options portfolio while ensuring all other risks inherent in such a portfolio are covered. A VaR model is an alternative to a CAD1 model, and is based on a risk management model which uses a statistical measure to predict profit and loss movement ranges with a confidence interval. VaR covers general risk and may also cover specific risk. If specific risk is not covered then the standard methodology should be used. VaR models are different from the standard methodology in that VaR models may take into account correlation between different risk types and, therefore, may recognise capital benefits of risk diversification of a trading portfolio. The rules on calculation of exposures arising from underwriting commitments are based on the assumption that the final exposure an underwriter takes up is normally significantly less than the underwriting commitment. This is because the trading book regime is based on an assumption that most, if not all, trading book positions will be successfully liquidated. Calculation of counterparty credit risk In general trading book positions attract a regulatory charge based on market risk rather than credit risk on the issuer. However in some circumstances (eg unsettled trades and repo transactions) credit risk must be reflected in the trading book as well. For example, credit losses under a repo transaction may arise if, at the time of default, the close-out value of collateral held is not sufficient to replace the exposure in the market, or the amount of posted collateral exceeds the firm's obligation to its counterparty. This is also the case where a position is taken synthetically (for example, via an OTC derivative) where the firm is exposed to both the credit risk of the derivative counterparty and fluctuations in the price of the underlying exposure. This risk is referred to as counterparty credit risk the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. If the transaction has a close-out value greater than zero at the time of default of the counterparty, the firm will suffer a credit loss. Calculation of counterparty credit risk is based on measuring the exposure value for a position arising from a financial derivative or a securities financing transaction (SFT). Given the nature of the transaction, counterparty credit risk exposure arising from a derivative fluctuates over the life of the transaction as underlying markets move and, accordingly, it must be measured in a way which takes into account potential future fluctuations in the price of derivative. For example, an interest rate swap may have a positive or negative value over the life of the trade depending on the movement of swap rates. Therefore, measuring the value of the current exposure (the MTM of the transaction) alone is not sufficient, an assessment of the potential future exposure (PFE) of the transaction must be carried out. Once the exposure value is assessed, it is then included in the firm's credit risk requirement calculations in accordance with the applicable approach used by the firm (either under the Standardised or IRB approach to credit risk). The approach to credit risk in the trading book will follow on the approach used in the banking book. Where a bank uses the Standardised Approach in its banking book, it will use that approach to calculate credit risk in the trading book, and where it uses the IRB approach in the banking book, it will use the IRB approach in the trading book. Financial derivatives Exposures to any particular counterparty are calculated on a net basis provided that a legally enforceable netting agreement is in place. There are three alternative methods available for calculating an exposure arising from over-thecounter (OTC) derivatives: the MTM method; the standardised method; and the internal model method. These methods are available to a firm irrespective of the firm's overall approach to credit risk. For example, a firm on the standardised approach to credit risk may choose to use an internal model method. MTM method This is the most basic method which pre-dates the CRD. Under this method an exposure is determined as the MTM plus the PFE where the PFE is a percentage of the notional value of the contract. The PFE depends on the product type and its maturity. Standardised method Allen & Overy

6 The standardised method is more advanced and provides more risk-sensitive calculations. Under the standardised method risks may be bucketed at a more granular level and risk position are measured more accurately rather than simply using the notional value of the contract. Internal model method The internal model method is the most sophisticated approach to calculating the exposure value of financial derivatives. This method is based on an effective expected positive exposure (effective EPE) method. This provides the most risksensitive approach to calculating exposure values and is aligned to the firm's internal risk management practices. Firms must apply for an FSA waiver before they are able to use this method and they must demonstrate that they meet certain quantitative and qualitative minimum criteria. Netting requirements Rules and guidance on netting requirements are specific to each method but also contain common netting requirements which include the general requirements for appropriate contractual netting agreements and legal recognition of netting arrangements. Securities financing transactions Generally, if the firm has an internal model method permission it may treat securities financing transactions (eg repos or stock lending) in accordance with its FSA permission. Alternatively, if the firm has an FSA permission for a master netting agreement internal models approach, which is an approach available within the credit risk mitigation framework, it must treat such transactions in accordance with that approach. In the absence of either of the above FSA permissions, the firm must treat securities financing transactions in accordance with certain prescribed rules within the credit risk mitigation framework. TRADING BOOK COMPLIANCE Valuation In addition to the valuation requirements mentioned above, firms are also required to carry on price verification at least monthly by a unit independent of the dealing room, and should aim to value the whole of the trading positions held within the trading book. Independent price valuation is separate from marking to market valuation, and should be performed to a higher standard than daily marking to market. Where considered necessary, haircuts should be applied to valuations where the price obtained may not be robust. All applicable haircuts and provisions must be taken into account in establishing regulatory capital requirements. Banks are also required to consider making provisions where a position is illiquid, highly concentrated or otherwise likely to be difficult to dispose of at the market valuation. All such provisions must be reflected in the regulatory capital calculations. Trading book policies and procedures In addition to valuations, firms are required to have robust trading book policies and procedures which address: the activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes; the extent to which an exposure can be marked-to-market daily by reference to an active, liquid two-way market; for exposures that are marked-to-model, the extent to which the bank can: identify the material risks of the exposure; hedge the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market; and derive reliable estimates for the key assumptions and parameters used in the model; the extent to which the bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner; the extent to which legal restrictions or other operational requirements would impede the bank s ability to effect an immediate liquidation of the exposure; Allen & Overy

7 the extent to which the bank is required to, and can, actively risk manage the exposure within its trading operations; and the extent to which the bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers. RELATED AREAS See Regulatory Capital Briefing 3 (Standardised Approach to Credit Risk in the Banking Book) and Regulatory Capital Briefing 4 (Internal ratings based approach to credit risk in the banking book). CONTACT INFORMATION For further information please speak to: Bob Penn Partner bob.penn@allenovery.com Damian Carolan Partner damian.carolan@allenovery.com Paul Phillips Partner paul.phillips@allenovery.com Irina Molostova Associate irina.molostova@allenovery.com Charlotte Phipps Business Development Co-ordinator charlotte.phipps@allenovery.com or your usual Allen & Overy contact. Allen & Overy

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12 Allen & Overy is an international legal practice with approximately 5,500 staff, including some 500 partners, working in 29 major centres worldwide. Allen & Overy LLP or an affiliated undertaking has an office in each of: Abu Dhabi Amsterdam Antwerp Bangkok Beijing Bratislava Brussels Bucharest (associated office) Budapest Dubai Düsseldorf Frankfurt Hamburg Hong Kong London Luxembourg Madrid Mannheim Milan Moscow New York Paris Prague Riyadh (associated office) Rome Shanghai Singapore Tokyo Warsaw In this brochure Allen & Overy means Allen & Overy LLP and/or its affiliated undertakings. The term partner is used to refer to a member of Allen & Overy LLP or an employee or consultant with equivalent standing and qualifications, or an individual with equivalent status in one of Allen & Overy LLP s affiliated undertakings. Allen & Overy maintains a database of business contact details in order to develop and improve its services to its clients. The information is not traded with any external bodies or organisations. If any of your details are incorrect or you no longer wish to receive publications from Allen & Overy, please contact charlotte.phipps@allenovery.com. Allen & Overy LLP This brochure is for general guidance only. Reliance must not be placed or decisions taken on the basis of its contents without specific advice. CS (Cover Only) CS indd 2 8/5/09 10:57:00